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Ring of confidence – Aggregating individual forecasts can reveal if some are overly optimistic

30/10/2013

Ian Kelly

Fund Manager, Equity Value

A well-known psychological experiment undertaken in Sweden in the early1980s found more than three-quarters of participants rated themselves among the top 50% of all drivers in terms of both skill and safety. It is a neat illustration of how human beings can be prone to overconfidence in their own abilities – something that can of course spill over into the way companies operate.

Car stock analysts have a rule of thumb that, if you add up each individual company’s sales forecasts for three years down the line, the total will be around 30% more than the wildest expectations for the entire market. Naturally it is possible to make a good case for individual companies growing profits and sales dramatically and sustainably – a new model, a cost-cutting programme and so forth – but never for mature markets as a whole.

The problem is that, when you look at the car market in aggregate, everybody is doing the same sorts of things. as a result, competitive realities kick in and those hugely confident three-year forecasts will never become reality. interestingly, something similar now appears to be happening in the us telecommunications sector.

Arete research kindly crunched some numbers for The Value Perspective on the sector’s ‘big four’ of ATt&T, Sprint, T-Mobile US and Verizon Wireless to find what we might loosely call their ‘cash profits’ – or, if you would prefer to be technical, their earnings before interest, tax, depreciation and amortisation minus their capital expenditure.

For some years, the combined cash profits total for the four businesses has hovered around $34bn or $35bn but, all of a sudden, it is now expected to be more than $43bn in 2014 and just shy of $50bn in 2015. Once again, you could make a case for one or two of the companies improving on past performance but, taken as a whole, that looks to be an improbable leap in profitability.

The US telco sector is a classic example of the way mobile telephone markets tend to work, with a couple of groups thriving, a third doing less well and a fourth just struggling to survive. In the US, AT&T and Verizon make 40% margins – significantly above European averages – T-Mobile US makes 30% margins and Sprint, which has effectively been on its knees for a while now, makes 12.5%.

Now, however, the forecast is that AT&T and Verizon will marginally increase their profitability and also grow massively while the other two will not only recover but continue to grow. Such an eventuality would require everybody to play very nicely indeed and that, bearing in mind what we said earlier about competitive realities kicking in, seems optimistic.

It seems even more so when one looks at Europe where, for example, T-Mobile’s owner Deutsche Telekom is actually expected to see its cash profits decline over the next couple of years. Evidently, however, there are still high hopes for US telcos – though the concern has to be to what extent this stems from the market extrapolating the expanding margins of recent years into the future.

For, importantly, a lot of the tailwinds that have helped drive this margin expansion are set to disappear as, under the new ‘4g’ bandwidth technology, customers will be able to move freely between local network operators. while such ‘roaming’ has been standard in Europe for years, it has not so far been possible in the US because different networks have operated on different frequencies and technologies.

Yet, even though that will no longer be the case, the market still expects US telcos’ cash profits to grow significantly from their recent steady levels. You might make a case for one or two businesses managing that but not the entire industry – and that has implications for UK investors because about a third of Vodafone’s market capitalisation is based on shares UK investors will receive in Verizon, following its sale of its stake in Verizon Wireless.

Human beings – and the companies they run – can grow overconfident about their own prospects because they believe they have control over all the variables. one way to guard against the unrealistic expectations that can result is, when working with estimates for one part of an industry, to add them all up to see what that implies for the sector as a whole. Do the numbers still make sense?

Author

Ian Kelly

Fund Manager, Equity Value

I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth.

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